The Looming Battle: Fundamental vs. Traditional Indexing

If the idea works, those who bet on it make money. If it doesn't work, they lose money.

Today, the biggest idea battle in investments is between "fundamental indexing" and "market-capitalization indexing."

In traditional market-capitalization indexing you replicate an existing market exactly as it exists. Then you trust that you'll earn the return of that asset class, less tiny fees.

The best-known example of this is the Vanguard 500 index fund. The object of mockery when it was launched in 1976, it has done better than 70 percent of its managed large-cap blend competitors over the last 10- and 15-year periods. Along the way it has accumulated nearly $70 billion in assets. It thrived while multitudes of managed competitors were quietly buried.

The first recent challenge to traditional indexing came from Robert Arnott and his firm, Research Affiliates. Launched last December, the Powershares RAFI 1000 index (ticker: PRF) returned 14.65 percent for the first 10 months of this year, while the Vanguard 500 index returned "only" 11.90 percent.

During the summer, Wisdom Tree began a full-scale assault on market-capitalization indexing. It launched an arsenal of 20 "fundamental index" exchange-traded funds that cover the major markets of the entire world. "In contrast to cap-weighted indexing, fundamentally weighted indexes anchor the initial weights of individual stocks to some metric of fundamental value," the Wisdom Tree Web site says.

While the RAFI 1000 index is based on a basket of fundamental measures, the Wisdom Tree funds are keyed to a single fundamental -- dividends. They do this because "cash dividends provide an objective measure of a company's value and profitability -- one that cannot be manipulated by accounting schemes."

Basically, the indexes give us the hope of being paid more now while we hope to be paid still more in capital gains later. Back-testing them from 1980 through 2005 showed that the idea appears to work. Wisdom Tree Dividend index returned 14.71 percent annually, while the Wilshire 5000 index returned 12.87 percent. Similarly, the Wisdom Tree Small Cap Dividend index returned a whopping 17.15 percent, while the Russell 2000 index returned 12.14 percent.

Over the 10 years ending March 31, 2006, Wisdom Tree's Pacific ex-Japan High-Yielding Equity index returned a stunning 16.66 percent, while the MSCI Pacific Rim ex-Japan value index returned only 6.91 percent and the MSCI Pacific Rim ex-Japan index returned 5.65 percent.

Does this mean we should pile in?

I don't think so. When you index stocks with primary attention to dividends, you create a portfolio that is likely to be concentrated in a few industries. You also create a portfolio that is highly sensitive to interest rates.

Purchase the Wisdom Tree Small Cap Dividend index ETF, for instance, and you'll be purchasing an index that is a whopping 60 percent financial stocks. That's almost three times the weighting of financial stocks in the Russell 2000 index.

Purchase the Wisdom Tree Large Cap Dividend fund and 30 percent of your money will be committed to financial stocks. (In contrast, only 22 percent of the Standard & Poor's 500 index or the Russell 1000 index is in financial stocks.)

Why should we worry about this?

History.

Electric utility stocks were the darlings of the early 1960s. They were praised for their high yields and their healthy growth rates. Those who invested with enthusiasm suffered for nearly 20 years while interest rates rose and price-to-earnings multiples collapsed.

The same fate may await a portfolio dominated by financial stocks.

Decades of research show that there are only two consistent sources of higher returns in the stock market: small-cap stocks and "value" stocks -- those with low price-to-book-value ratios. Those are the areas for fundamental indexing to pursue.

Skeptics should consider the track record of Dimensional Funds Advisors, the original fundamental indexer. Its Small Cap Value fund, a rules-based fundamental index, has returned 15.60 percent annually over the last 10 years. That puts it at the top of the small-cap value fund heap.

Similarly, its Large Cap Value fund has returned 12.08 percent a year over the last 10 years, placing it in the top 4 percent of large-cap value funds.

Why haven't you heard of them?

Simple: The minimum investment in either fund is $2 million, unless you work through a financial adviser.

This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational puposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.

AssetBuilder Inc. is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and expenses carefully before investing.